The treasury stock method is used to calculate the net increase in shares outstanding if in-the-money options and warrants were to be exercised. This information is included in the calculation of diluted earnings per share. The treasury stock method employs the following sequence of assumptions and calculations:
- Assume that options and warrants are exercised at the beginning of the reporting period. If they were actually exercised later in the reporting period, use the actual date of exercise.
- The proceeds garnered by the presumed option or warrant exercise is assumed to be used to purchase common stock at the average market price during the reporting period.
- The difference between the number of shares assumed to have been issued and the number of shares assumed to have been purchased is then added to the denominator of the computation of diluted earnings per share.
For example, a company has in-the-money options outstanding for 10,000 shares, which can be exercised at $5 per share. The average market price for the reporting period was $12. The company will receive $50,000 from the exercise of the options, which will also create 10,000 new shares. If the company were to use the $50,000 proceeds to acquire shares on the open market at $12 per share, it would be able to purchase 4,166 shares, which represents a net increase of 5,834 shares outstanding.
This is a required calculation for a publicly-held company, since all public entities must report their diluted earnings per share on the face of the income statement. The only exception is when a business has such a simple capital structure that the diluted earnings per share figure is the same as its basic earnings per share.